Japan’s deregulation: When catastrophe leads to innovation in a stagnant energy market

Japan's nuclear disaster is now presenting new opportunities through the deregulation of its electricity market.
Published: Wed 18 May 2016

It is only five years ago since the 15m tsunami left Japan in tatters. It completely disabled power supply and cooling systems for three Fukushima nuclear reactors which provided a large portion of the country’s electricity.   

This natural disaster had the world questioning the safety of nuclear energy while Japan came to terms with the complete devastation caused by the nuclear disaster. The country had to quickly find immediate solutions to its energy sector and economy-challenges that persist to this day.

Japan’s energy crisis

Since the accident, Japan’s energy prices have escalated, leaving the country with rates that are among the highest in the world. This increase is mostly due to the heavy reliance on fossil fuel imports— namely, oil and LNG—which now make up 85% of Japan’s energy mix, costing up to $40 billion per year. The country has not had much choice since it relied heavily on its nuclear energy. Japan has gone from operating 35 nuclear reactors to just two.

Increased costs, combined with the shutting down of nuclear plants, have left Japan’s power monopolies in trouble. The disaster has cost the country at least $110 billion.

Companies like TEPCO keep losing money. The net income of Japan’s Electric Power Companies (EPCos) is still just over half of what it was before the disaster.

This serious debt is reflected in the high tariffs which consumers have no choice but to pay. Electricity bills have risen about 20% over the last five years and as a result, consumers have lost faith in their monopoly power companies and are demanding change.

Disaster leads to opportunity in the energy sector

Part of the solution to challenges that plague the country’s energy sector is the deregulation of its electricity market, both generation and retail. If this is done successfully, the change will modernize and innovate Japan’s energy sector and bring prices down thereby boosting an ailing economy.

The Japanese electricity market has the market size of $150 billion so the deregulation will make Japan one of the world’s largest deregulated electricity markets in history, enabling Japan to become a global model.  

The idea of deregulation in Japan is not new. Japan tried to follow America’s lead in the 1990s to cut prices, improve efficiency and boost innovation and business opportunities both locally and further afield. However, attempts were thwarted mostly by monopoly power companies like TEPCO who wield strong political influence.

Before Fukushima, most government officials did not believe it was possible to fully deregulate the sector. But, various factors as a result of the disaster, have forced Japan to seriously reconsider deregulation. Until now, the sector had very little incentive to improve.

The deregulation could bring much-needed competition to the market, enabling the ailing electricity sector to become more efficient and thereby decreasing energy costs.

Deregulation opens the door to innovation

Already, new entrants from a number of industries are lining up to introduce new business models to the sector.  These include the bundling of costs of mobile phones, Internet and electricity.

As new players enter the market and companies are compelled to push for efficiency, this will encourage technological improvements in devices like smart meters, home and building energy management systems and efficient power generators. With more local renewable companies entering the market, the renewable energy sector can also expect to see a higher level of innovation.

This increased level of competition and innovation in the sector will boost the country’s economy further as these are exported around the world.

Japan also has the opportunity to lead the way in creating new, innovative policies to ensure lower prices for consumers and an improved economy. This can be done through the creation of a dynamic pricing system which charges a higher price during peak times, thereby reducing energy consumption.  

Key factors to the success of the reform-lessons from abroad

There are four points that are key to the success of the reform, according to Koichiro Ito, Assistant Professor, Harris School of Public Policy:

Firstly, the government has to get through all the steps proposed by the current administration. Retail deregulation took place this April, but the unbundling of the transmission sector won’t occur until 2020.

Secondly, there must be fair access to transmission and distribution lines. Without this access, proper competition even if new companies want to enter generation or retail markets will not happen. Japan plans to implement “legal unbundling,” which leaves a financial relationship between an unbundled transmission company and its parent company, which is a current local monopoly.

The legal unbundling isn’t as assuring as the methods of unbundling taken by other countries in the past, and it requires continued monitoring from regulators. For instance, many states in the US and EU countries left the ownership rights of transmission lines to local electricity companies, but moved the operation of transmission lines to public third party entities (so called, independent system operators or ISOs), completely removing the operation of transmission lines from local monopolists. One of the benefits of having public third party entity operating the transmission lines is that they ensure fair access to transmission lines for both incumbents and new entrants. For example, it addresses concerns over delivery charges being set at an expensive price in order to prevent new entrants from entering the market.

In the case of Japan’s deregulation, there will be room for transmission line companies and local electricity companies to continue having close relationships, and there will be an incentive for transmission companies to provide fair access to new entrants. For this reason, it is critical to the success of the reform whether newly established regulatory bodies such as the Organization for Crossregional Coordination of Transmission Operators, Japan (OCCTO) and the Electricity Market Surveillance Commission (EMSC) can closely monitor fair access to the transmission lines on a continuous basis.

Thirdly, it is questionable that competition will lower generation costs. Deregulating the generation sector has already been introduced legally, but the quantity of electricity generated by new entrants is so small that the generation share of the vertically integrated local monopolies exceeds 90%.

What happens if the generation sector remains as-is and the retail sector competition takes place? Since generation cost does not change, consumers’ total payment won’t change. What could end up happening is that the only real change that takes place is the shift in who makes the sale - from local monopoly companies to new companies - without any significant change to price. From a consumer’s point of view, there is little benefit to retail deregulation if the price does not change much.

There are multiple ways to promote competition in the generation sector. Common methods taken by many countries are either to separate the power plants from vertically integrated firms or to let them divest their generation capacity. Either of these methods creates more competition by setting the environment where existing and new power plants stand equal. It is also important to promote competition in wholesale markets. Currently the amount of electricity marketed in the wholesale market in Japan is merely 2% of the total electricity generated, which is very low compared to other countries where is typically over 50%.

Lastly, it is important to promote competition and create value-added innovative services in the retail sector. There is little room for the electricity price to decrease unless there is competition in the generation sector. However, there is a potential for a slightly lower retail price or improved quality of services if retail services become more efficient by bundling with other products such as mobile, internet, gas, fuel bills.

Moreover, the introduction of dynamic electricity pricing can provide value-added services. Post the 3/11 earthquake, people in Japan were given the message that “there is electricity shortage in all hours,” but this is misleading. Japan’s electricity is scarce at peak demand hours such as summertime afternoons or winter early evenings. However, there are hours during the day when the electricity supply is abundant. Dynamic electricity pricing sets the electricity price lower when the cost is lower, encouraging the smarter use of electricity and as a result, a cheaper electricity bill for the customer.

Merely five years after one of the world’s most catastrophic events, Japan finds itself in a unique position- the ability to reinvent its energy sector and economy as whole.

Ironically, these opportunities probably would never have come to light if it weren’t for one of the world’s biggest catastrophes.

Further reading

Energy Policy Institute at the University of Chicago- Deregulation of Japan’s Electricity Market: Key Factors Needed for Success